Stock Market Investing: The action of the equity markets over the last couple of weeks has been, to say the least, suspect. Today, the averages are testing support at the 50-day moving average and the uptrend line that goes back to March, the beginning of this Fed induced, government sponsored rally. For your edification I will highlight just a few of the warning signs:

Too many distribution days.

The bullish percentage of NYSE stocks in bullish trends is declining.

The percentage of NYSE stocks trading above their 50-day MA is declining.

The Transportation Average has broken down with Rail stocks leading the way (more on Rails later). Last week’s price action resulted in an “Outside-Down” week extremely negative behavior.

Momentum as judged by the MACD declined significantly on the markets last advance.

The averages were unable to reach the top of their respective channels on the last advance, which often happens at the end of an uptrend. This action signifies the buyers are exhausted.

Even with all these negative developments, the Daily Sentiment Index remains in rarefied territory at 87 %. In 22 years of tracking this number, 87% or higher was reached or exceeded only 5 times. The bulls are ripe for slaughter.

The ultimate question: What happens to a Fed induced, government sponsored rally when the punch bowl is taken away? Probable answer: The drunks left standing around the table get rolled. Investment Strategy: Batten down the hatches we are in for a blow (pun intended).

The US$ is at the epicenter of the mayhem unfolding in equities. I have been writing for weeks that if the US$ continues to slide asset prices will continue to fly in an inflation induced rally. Well, over the last week the US$ has rallied off the lows and asset prices, in a mirror image, have suffered.

The reasons behind the US$’s advance offer the keys to understanding the magnitude and perhaps the duration of the asset price decline.

To begin, this week marks the completion of the $300 billion Fed program to participate in Treasury auctions. In other words, the Fed is curtailing Quantitative Easing for the moment. This change in QE alone would be enough to rally the beleaguered US$, if for no other reason than a relief rally. However, other reasons for the US$ advance abound.

As Jim Sinclaire explains, “November 4th is the FOMC meeting most likely to contain discussions of timing for the exit from economic stimulation.” Many questions have been thrown at the Fed about exit strategies and in the event that Nov. 4th may offer some answers the US$ is repricing.

Jim further explains, “November 7th is the G20 meeting at which BRIC nations will anticipate a cessation of QE and a commitment to establish a currency alternative to the US dollar.” The best way to delay the movement away from the US$ as the supreme currency is to induce a spirited rally in front of said meeting.

However, can the Fed really afford to reduce the QE? Without Fed buying of Treasuries, rates will surely rise. I will emphatically state that the US economy is in no shape to withstand a raise in rates. Please don’t believe all the cheerleading you hear on CNBC about good earnings and economic recoveries. The majority of “good” earnings have been gained through creative accounting (financials) or inventory builds, not real economic growth due to consumer demand.

An economic recovery is not sustainable sans consumer demand and the numbers out today paint a bleak picture: Briefing, “October Consumer Confidence 47.7 vs 53.5 consensus, prior 53.1″ Consumers know reality and feel the difficulty of the economic situation. Every day CNBC programming moves farther away from reality which may explain why “Nielsen reported a 50% plunge in CNBC viewership in October year over year. CNBC has experienced a massive 52% decline in overall viewers during business day hours (5 am – 7 pm), and a not much better 49% drop in its demo (25-54) in the month of October as compared to last year October 30th.”

Appearances would suggest that the Fed is stuck between a proverbial rock and its corresponding hard place: Continue QE at the risk of the US$ or stop QE at the risk of economic recovery. I, however, would like to offer an altogether different and more troubling take on the situation for the equity markets. I will ask you to accept as a given that the treasury market and the direction of interest rates is more important to the Fed than the equity markets. If you accept this opinion then walk with me a little bit further and acknowledge the fact that as the stock market sells off fear drives investors into the treasury markets. Can you see where I’m going with this?

Until the Fed is ready to resume QE, it is in the best interest of the authorities to have the equity markets sell off and fear to grow thus driving the herd into treasuries to fill the void the Fed’s exit creates.

About Bret Rosenthal

Interpreting the news that moves markets. Principal of RCM, LLC, and founding partner of the Fortune's Favor Family of Funds